Value capture and defensibility
How crypto networks can capture value and establish competitive moats without shifting from minimal to maximal value extraction over time.
|Alexander Lange||Nov 25, 2020||3|
Crypto protocols are coordination technologies, not companies. They are orchestrating market participants through self executing code what makes them orders magnitude more efficient than previous coordinators - like platform businesses. As assets and data are owned and controlled by users and their underlying code base is open sourced (can be forked anytime) controversies arose around their ability to capture value and establish competitive moats. I am applying first principles and established frameworks to make the case for crypto networks capturing significant value through their underlying assets.
There are some businesses that have very large moats around them and they have crocodiles and sharks and piranhas swimming around them. Those are the kinds of businesses you want.” - Warren Buffet
A framework for value capture
Following Brandenburger and Harborne Stuart value creation by a firm is based on a simple equation:
Value created = willingness-to-pay – (opportunity) cost
The value a company creates is the delta between the revenues it gets by selling its product or service and the costs of producing that product including the opportunity cost of capital. The dominant strategies to create more value are: increase the willingness to pay of your customers; reduce the willingness to pay of the customers of your competitors; reduce the opportunity cost of your suppliers; and increase the opportunity cost of suppliers to your competitors.
All of that can be achieved through competitive moats.
A business creates X Dollars and captures Y% of $X. X and Y are independent. The lesson for entrepreneurs is clear: if you want to create and capture lasting value, don't build an undifferentiated commodity business. - Peter Thiel
How are defensible businesses shaped? In his paper Measuring the Moat Professor Michael Mauboussin describes three broad categories of added value that are conditional for sustainable value extraction: production advantages, consumer advantages and external advantages.
Production advantages are achieved through cost efficiencies driven by process and scale economies - e.g. Product complexity, resource uniqueness or protection through IP, purchasing power or distribution at scale. Companies with strong competitive moats on the production side come with high asset turnovers but low margins.
Consumer advantages are achieved by outperforming competitors on the benefit side, e.g. through the establishment of consumer habits, high switching costs and customer lock in effects. Companies leveraging consumer advantages come with low asset turnovers but high margins.
External advantages can be summarized as government related, e.g. tax rates, tariffs or new regulations like Basel III or GDPR.
Big tech's value capture is driven by various moats: Complex products are protected through patents (e.g. google's search algorithm) often coming with data network effects. More users increase the inflow of proprietary data which is used to improve the algorithms at the core of a product to attract even more users etc. - a flywheel. Over time network effects can turn into lock in effects preventing customers or suppliers from switching platforms - e.g. AirBNB hosts want to distribute their services on the platform with the broadest and most dense customer base. The same is true for advertisers (facebook), drivers (uber) or developers (iOS, Android). These economic lock in effects are amplified through technological ones such as locked up data silos preventing users from porting their data from one service to another. Consequently, software platforms operated by companies end up shifting from positive sum to zero sum relationships with their network participants as described by Chris Dixon.
However, market conditions are changing rapidly. Investors and entrepreneurs have become weary of building or backing companies that are heavily dependent on software platforms. Regulators are increasingly using their anti trust toolset to reduce big tech's (abuse of) market power expressed in closed APIs, censorship and the discrimination of competitors. In parallel a next generation computational platform is rising to undermine some of the competitive moats big tech is built on:
Enter Crypto Networks
As outlined in stakeholder owned software networks crypto protocols aren't companies, they don't have income statements. They are a new type of coordination mechanism facilitating exchange in global markets.
As correctly brought forward by critics - most of the production and consumer advantages do not apply:
even though many crypto networks offer complex products, none of those are protected through IP rights - they are built on open source code
data network effects don't occur under an open data logic where information is floating freely across the web and can be accessed by everyone through open APIs that cannot be shut down
consumer lock in effects don't apply where data and assets are controlled and owned by users with near zero switching costs
However, crypto networks are capturing value today and they have competitive moats. The bigger questions are to which degree they will leverage those advantages against competing protocols in the future and if their relationship to users and complements will shift towards extraction and competition or not.
Value capture through fees
As of today crypto networks do capture value by charging their customers with fees.
They are orders of magnitude more efficient than any software or financial services company could ever be. That is because markets are orchestrated through raw software in such ways that the counter-parties can transact pseudonymously over the internet. Distribution and reach are global from day one. Transaction costs are near zero because commercial agreements are standardized and implemented through code (no lawyers needed). The parties don’t bear any law enforcement risks as their agreements are programmatically executed (no courts needed). Consequently, the fees charged by suppliers or - where applicable by the network itself - are significantly lower, e.g. you can send $1BN worth of Bitcoin around the globe for a few dollars or store 1 GB of data on IPFS for $0.018 vs. $0.276 on Amazon S3 standard.
Currently, crypto networks are minimally extractive what doesn't imply their inability to capture value - with low margins but high asset turnovers they fall into the 'production advantage' category above.
Evolving competitive moats
Which are the competitive advantages a crypto network might establish over incumbent services and competing protocols going forward?
Network effects can be established on both or multiple sides of the market. On the supply side they can be triggered through outsized revenue potential for suppliers (minders) including additional rewards paid out by the protocol through programmatic distribution / inflation (see below). Demand follows where new or cheaper and better services are offered.
Standards and integrations
Integrations are key to drive network effect across ecosystems. Adversarial interoperability allows third parties to plug into a protocol or service without asking for permission what often drives adoption and enables higher degrees of composability.
A platform is composable if its existing resources can be used as building blocks and programmed into higher order applications. Composability is important because it allows developers to do more with less, which in turn, can lead to more rapid and compounding innovation. - Jesse Walden
The systematic adoption of programming languages (e.g. solidity) through educational formats (e.g. universities) and modules for algorithms, code (ERC20, ERC721) or governance (compound governance) are related examples.
Strong, trusted brands can drive network effects on all sides of the market. It has been empirically proven that brand popularity does not translate into value creation. However, things might look differently in the context of crypto networks as their major value add is the enhancement of trust between market participants. Security and reliability are the leading indicators for trust in a crypto network’s brand followed by features, usability and pace of iterations for example. Crypto networks will turn into the public infrastructure backbone to the web and future financial system. Hence, a trusted brand will have a much bigger effect on attracting and binding stakeholders than it has in other industries.
Ownership lock in effects
Ownership lock in effects are a crypto native factor underpinning competitive moats. Beyond store of value assets (Bitcoin, Zcash, Decred etc.) they aren’t very well understood yet. A network’s underlying asset can be distributed programmatically based on work or other resources that have been provided to the network like electricity (Bitcoin), storage (Filecoin) or video transcoding services (Livepeer) - generalised mining. How exactly value is distributed within a given protocol is one of crypto’s core areas of innovation spanning various incentive designs like work tokens, staking, protocol taxes, bun and mint mechanisms and much more.
Most networks have been built around the implicit assumption that market participants who hold a share in the network will be loyal - they have been proven wrong. Liquidity (or any other supply side service) isn't loyal, especially not in an environment of astronomic opportunity costs.
This doesn't mean that ownership lock in effects won't be achieved in the future. Dynamic supply schemes factoring in time, total and relative resources / work contributed to the network or reputation systems will be explored further to achieve higher degrees of economic resilience. Extended, programmatic lock up periods or progressive asset utility schemes might be parts of a solution - e.g. governance rights increase over longer holding periods, relative staking rewards increase with the amount and quality of work / resources provided over time etc. The design space is huge.
Governance rights are often closely related to ownership lock in. Stakeholders who earned themselves a say in a network have an economic incentive to stay on board as it allows them to influence external factors impacting their markets - regulation. Through votes they have the opportunity to align the protocols policies with their own economic interests. As of today we are far from sophisticated governance mechanisms as fundamental building blocks for more systematic and insightful innovations are still lacking, e.g. identity standards.
All of these factors in combination - and probably many more - are likely to establish competitive moats around open source crypto networks over time. Once these moats are in place, a given protocol would have the opportunity to extract more value from the economy it is orchestrating. Chris Dixon’s s-curve from above would apply here as well until the next open, computational platform rises.
With competitive moats established - will crypto networks shift from minimal to maximal value extraction?
With a growing ecosystem and more capital entering the space, what will prevent crypto networks from becoming as extractive as their predecessors, or even more so?
Governance should be the answer. If crypto networks are owned, operated and governed by network participants - not shareholders - they will optimize for a healthy economic equilibrium without forming mega monopolies. But will they?
The answer will heavily dependent on
how exactly governance is implemented
how a network’s distribution scheme is defined and consequently,
how the stakeholder structure looks like at any given point in time
If significant supply of a network's underlying asset is controlled by profit seeking investors and most operational stakeholders are selling their shares immediately after distribution the more likely a maximal extraction scenario becomes. As a community of innovators we have a shot of finding new ways of improving shareholder capitalism but it will take time.
Conventional frameworks for value capture and strategic competitive advantages can be applied to crypto networks. They are creating and capturing value today and are likely to establish competitive moats over time. Once they are in place governance mechanisms and stakeholder structures will define how extractive crypto networks will become and which relation to their users and complements they will have.
If you see things differently, have feedback or would like to share some additional thoughts on value capture and defensibility please